Imagine an investment approach where you can fund an early stage company and not have to worry about – or wait for – a blockbuster IPO or acquisition many years out before realizing a return on your invested capital.
Angel and venture capital investments are traditionally defined as an equity stake in an early stage company where the investor provides funding when the business risks are high but the potential payout is also very large. While VC still is largely a “home run” investment approach, angels and some smaller funds are applying an innovative approach to early stage investing that still includes higher risk and reward, but is more of a “base hit” investment approach.
Royalty-based deals are not new, but the use of this funding approach for early stage companies is somewhat novel. For decades, oil and gas companies have used this deal structure to finance prospecting activities.
How It Works
In a nutshell, a royalty-based investment is more of a debt instrument (liability) instead of equity. While the actual financial structure may vary, the gist of the deal is a company borrows money and agrees to pay a royalty (percentage of its gross revenues) until a defined multiple of the original investment has been repaid.
One example: a company borrows $200,000 and agrees to pay 10% of its gross revenues to the lender until $800,000 has been repaid. This may take one year or ten years. The return of 4x may seem excessive to a borrower, but it may take many years to repay, so there is more risk to the lender than a typical commercial loan, and unlike a conventional angel investment, the company may not be giving up any or much equity (yes, an equity component could be incorporated into this structure).
Ideal Candidates (Early Stage Companies) for This Type of Financing
Royalty-based deals typically require the company to already be generating a reasonable stream of revenue. If a startup is still in the “pre-revenue” stage, most of the royalty-based venture financing firms will not be interested.
Royalty Capital New England (http://www.royaltycapital.us) from Boston does these types of deals
Revenue Loan (http://revenueloan.com) based in Seattle also does these types of deals
GigaOM Article from 2009 that talks about revenue based financing and coins the term “Class R Stock” (http://bit.ly/ClassR_Stock)
A video of a presentation from Growth Science International (http://www.growthsci.com) that discusses royalty-based financing: